Originally published on Forbes.com on June 28th, 2012
My friend Julian Block does not like to use the term Obamacare, but I find it pretty handy. The Act was upheld by the Supreme Court today by holding that the controversial individual mandate was a tax. We should not forget that there were other tax provisions in the bill that everybody knew were taxes. There is the excise tax on tanning booth services and a new tax on investment income, which Julian explains here.
Medicare Surtaxes Hike Taxes For Upper-Incomers
Bush-era tax rates are set to expire at the end of 2012, which would cause rates to become sharply higher. Even if they remain in effect, rates for upper-income individuals will move up in 2013.
The culprit is a comprehensive health care reform package that Congress enacted in 2010 (known officially as the Patient Protection and Affordable Care Act of 2010 and the Health Care and Education Reconciliation Act of 2010). The health-care legislation introduces Medicare surtaxes that increase taxes for higher-income individuals. Two distinctly different increases take effect at the start of 2013.
The first surtax is on earned income. For 2013 and later years, the additional Medicare tax of 0.9 percent applies only to joint filers with wages above $250,000 ($125,000 for married couples filing separate returns) and single filers over $200,000. Their employers pay nothing extra. The levy also applies to individuals with self-employment income above the thresholds.
The second surtax drastically changes the rules. Before 2013, the Medicare payroll tax applied just to wages, not investment income. The legislation expands it to apply to certain kinds of investment income. For 2013 and later years, the new tax of 3.8 percent kicks in only when MAGI exceeds specified amounts. MAGI is an acronym for modified adjusted gross income. It’s the same as AGI for almost all individuals except for expatriates. The law requires them to add back certain amounts that are excludable from U.S. income taxes.
The 3.8 percent tax applies only to joint filers with MAGI above $250,000 ($125,000 for married couples filing separate returns) and single filers with MAGI over $200,000. Even then, it’s imposed on the smaller of a person’s net investment income or the amount by which MAGI exceeds the threshold amounts of $250,000 ($125,000) or $200,000.
The legislation precisely defines investment income. It includes interest, dividends, capital gains on the sales of investments like stocks and bonds, annuities, royalties and passive income from rents and businesses you don’t actively participate in. There are exceptions, and they’re important. Investment income doesn’t include tax-exempt interest from municipal bonds or muni bond funds or withdrawals from retirement plans, such as IRAs, Roths and 401(k)s, life-insurance proceeds payable at death, veterans’ benefits and income from businesses you actively participate in, such as Subchapter S corporations or partnerships.
Be mindful of the rules for withdrawals from retirement plans. While such withdrawals are one of the exceptions, they’re reportable income and increase MAGI. The rules are more favorable for withdrawals from Roth accounts, another one of the exceptions. Roth removals don’t increase MAGI.
The3.8 percent tax doesn’t affect someone without investment income. Similarly, it doesn’t affect someone whose entire income is from investments, as long as total investment income is under the MAGI thresholds.
Assume 2012’s top rate of 15 percent for long-term capital gains and dividends remains in effect for 2013. The additional Medicare tax increases the top rate from 15 percent to 18.8 percent.
When the surtax does apply, here’s how the numbers work in 2013. Suppose a couple filing jointly has investment income of $100,000 and MAGI of $300,000. Besides their regular income taxes, they have to pay a surtax of $1,900—3.8 percent on the $50,000 excess over $250,000. This is because their MAGI of $300,000 reduced by their $250,000 threshold amount is less than their investment income of $100,000.
For a single person with investment income of $100,000 and MAGI of $400,000, the surtax is $3,800—3.8 percent on the income of $100,000. This is because her investment income of $100,000 is less than her MAGI of $400,000 reduced by her $200,000 threshold amount.
There’s lots of confusion about profits on sales of primary residences, because many newspaper articles assert that the 3.8 percent tax hits all profits after 2012. Not so. Most home sale profits are going to be exempt.
The health care legislation left unchanged the exclusions from tax for profits from sales of personal residences. Sellers qualify for the exclusion if they satisfy ownership and use requirements. They must own and live in the property as a principal residence or main home for periods that aggregate at least two years out of the five-year period that ends on the date of sale. The allowable exclusions are as much as $500,000 for married couples who file joint returns and $250,000 for individuals who file single returns or married couples who file separate returns.
Profits on home sales that sidestep capital gains taxes also escape Medicare surtaxes. The IRS insinuates itself only when profits exceed the exclusion amounts of $500,000 or $250,000. Even then, the portion of the profit above $500,000 or $250,000 is subject to the 3.8 percent tax only when MAGI exceeds the threshold amounts of $250,000 ($125,000) or $200,000.
Let’s say a couple realizes a profit of $600,000 on the sale of their dwelling. They are taxed at a rate of 15 percent on the $100,000 of long-term capital gain above their exclusion of $500,000 and might be liable for the new surtax.
Sellers with hefty profits should assemble documents that showing outlays that increase their dwelling’s basis and thus lower capital gains—for instance, settlement or closing costs, such as title insurance and legal fees, as well as what they later shell out for improvements, such as adding a room or paving a driveway, as opposed to routine repairs or maintenance that adds nothing to the place’s value, such as painting or papering a room or replacing a broken windowpane.
What about profits from sales of second homes and rental properties? The surtax applies to the entire profits. And those profits might move MAGI beyond the thresholds and trigger the surtax.
There’s more bad news. Investors must separately calculate the extra 0.9 percent wage-based tax and the new 3.8 percent tax on investment income. Assume a single person has wages of $180,000, investment income of $60,000 and MAGI of $220,000. She escapes the 0.9 percent tax and is billed $760 for the 3.8 percent tax on $20,000 (MAGI of $220,000 minus threshold of $200,000).
What happens when she has earnings of $300,000, investment income of $60,000 and MAGI of $400,000? Her wages of $300,000 put her $100,000 above the threshold of $200,000, boosting her tax tab by $900 ($100,000 times 0.9). She also is nicked for $2,280 (3.8 percent on the entire $60,000—the lesser of her investment income of $60,000 or the amount by which MAGI of $400,000 exceeds her threshold of $200,000). Her total increase is $3,180.
Long-standing rules authorize indexing (automatic annual adjustments to reflect inflation) for tax brackets, dependency exemptions and standard deduction amounts for individuals who choose not to itemize their spending on Form 1040’s Schedule A for write-offs like real estate taxes and payments of interest on home mortgages. But Congress decided against indexing thresholds for the 0.9 percent and 3.8 percent taxes. Therefore, persistent inflation, even at its present low levels, will erode the thresholds.
Whether by design or inadvertence, Congress created rules that require a person to pay more Medicare surtaxes solely because he or she is married. Congress allows two cohabitating singles to each have up to $200,000 in wages without exceeding the threshold for the 0.9 percent tax. Congress penalizes them if they marry. Wages above $250,000 exposes them to the 0.9 percent tax. Similarly, two cohabitating singles each can have MAGI of as much as $200,000 without exceeding the threshold for the 3.8 percent tax. If they marry, MAGI above $250,000 exposes them to the 3.8 percent tax. Their reward for a walk down the aisle is that they could become liable for both surtaxes.
With Washington’s cantankerous mood, it’s uncertain whether the Bush-era tax rates will be extended beyond 2012 or taxes will revert to higher rates in 2013. What could happen is that Congress and whoever is in the White House cut deals for more changes like the Medicare surtaxes: a few percent here, a few percent there, rather than straightforward rate increases or decreases. What’s certain is that our lawmakers will enact even more complications to an already confusing tax code.
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Julian Block is an attorney and author based in Larchmont, N.Y. He has been cited as: “a leading tax professional” (New York Times); “an accomplished writer on taxes” (Wall Street Journal); and “an authority on tax planning” (Financial Planning Magazine). This article is excerpted from “Julian Block’s Year Round Tax Savings,” available at julianblocktaxexpert.com.
You can follow me on twitter @peterreillycpa.